Q3-2018 Quarterly perspectives

Tavistock Wealth - Investment Team Outlook


Welcome to the Q3-2018 ‘Quarterly Perspectives’ publication

Half Year Review

So far this year, the portfolios have performed well in what has proven to be a challenging environment. Our decision to reduce exposure to global investment grade and high yield bonds contributed to fixed income performance as did our flattening yield curve strategy and new position in floating rate debt. Emerging markets, which performed well at the start of the year, have since suffered as trade tensions have ratcheted higher. However, our allocation to Smart Beta trading strategies such as minimum volatility cushioned against potentially greater EM losses. Our decision to increase the allocation to US small cap equities has enhanced performance too.

Key Themes

We’ve seen a pick-up in volatility in most financial markets this year, especially in the emerging economies. Our view is to look through the geo-political “white noise” and focus on the positive economic fundamentals. As such we continue to favour global equities, given earnings growth, low real yields and easy monetary policy. Whilst emerging market securities offer an additional layer of diversification and are trading at attractive valuations, the escalation in trade tariffs justifies a more cautious approach.

As a result, we have revised our tactical outlook for EM equity and debt slightly lower. We expect inflationary pressures to build, particularly in the US and UK, and maintain our underweight allocation to developed market government bonds and corporate credit. Our preferred asset class for the second half of 2018 is commodities, which we have upgraded one-notch. Commodities tend to outperform at the end of the economic cycle and should further benefit from our forecast for modest US dollar weakness in the coming months.

Chart of the Quarter

Quantitative tightening has been a key driver of asset class performance so far this year. The ECB and BOJ are still buying securities, but the ECB plans to terminate quantitative easing by the end of the year and the BOJ has started opportunistically trimming its balance sheet. The Fed is already reducing its balance sheet and is now rolling-off approximately $40 billion of  bond holdings each month. Despite slow and gradual normalisation, quantitative tightening has resulted in higher government bond yields, wider credit spreads and heightened market volatility.

Fixed Income

Fear of contagion from the currency crises sweeping Argentina and Turkey hit emerging market debt in the second quarter, causing a divergence between asset prices and underlying fundamentals. The long-term outlook remains positive and we continue to hold an overweight position. However, the recent geo-political trade-related tension has softened our view and we have reduced our near-term outlook for the asset class.

The US Federal Reserve has increased rates twice this year and we expect 4 additional quarter point rate hikes before the end of 2019. As a result, we prefer floating rate bonds and have positioned the portfolio for further yield curve flattening. Since entering the trade, the gap between the 2 and 10-year Treasury yields has declined from 75bps to 28bps.

We remain underweight global government bonds, and in February we reduced exposure to investment grade and high yield debt. We expect credit spreads to widen further, under the weight of further supply and a gradual rise in the default rate, which remains at a 10-year low of 2.1%.

Political uncertainty will keep European markets on a tightrope, just one anti-establishment party away from significantly wider sovereign yields. This instability could be magnified as the ECB looks to end its asset purchase programme at the end of the year. The UK bond markets remain highly unattractive given the high level of inflation and negative real yields.

US government bond yields have risen and global credit spreads have widened over the last few months


Despite a bumpy ride in equity markets this year, there is still value to be derived from this ageing bull market, supported by positive macroeconomic sentiment and strong corporate earnings.

We maintain a modest overweight to European equities as economic growth remains robust despite the recent slowdown. Europe’s relatively supportive monetary policy and attractive valuations versus the US should help overcome potential political and trade risk.

Over the past 18 months, our overweight allocation to emerging market equities has delivered strong returns, however the sector came under pressure last quarter from US dollar strength and simmering trade tensions. This is a position we will be monitoring closely in the near term as events unfold. We still see potential for further upside in the medium-term based on the macro fundamentals, cheap valuations and elevated commodity prices.

Going into Q3, trade conflicts remain a growing tail risk, which could elevate volatility across equity markets. We have therefore opted to rotate some of our emerging market equity exposure into a diversified mix of Smart Beta trading strategies and commodities.

We increased exposure to US Small Cap equities twice this year, participating in recent outperformance versus the S&P 500


Commodity markets are the best performing asset class so far this year. We maintain our overweight assessment and forecast returns of 10% over the next 12 months.

Commodities typically do well towards the end of the business cycle when demand outpaces supply. Strong global economic growth, depleting inventories and the potential for additional supply disruptions underpin our bullish outlook. We believe trade war fears have been overplayed and any impact will be small. However, any short-term escalation of trade rhetoric should not be ignored and is the main risk to our outlook.

During the quarter, we reduced exposure to commodity equities, which offer indirect asset class exposure, and increased our allocation to physical commodities via a swap-based ETF. Physical commodities are less vulnerable to growth concerns and rising interest rates. Also, they have lagged commodity equities over the last few years. This differential should dissipate as we near the end of the economic cycle. Our mildly bearish view for the US dollar is also supportive of higher physical commodity prices going forward.

Physical Commodities are cheap when compared to Commodity Equities

Sterling is historically cheap versus the US Dollar, which we forecast will weaken modestly into year-end

Foreign Exchange

Sterling declined -5.8% versus the US dollar in the second quarter bringing it to the middle of its one-year range. However, on a longer-term basis sterling remains undervalued, trading below purchasing power parity and its 5, 10 and 20-year averages.

This year the gap between US and UK short term interest rates has widened coinciding with a strong appreciation in the US dollar. However, for most of 2017, the US dollar fell despite higher US rates. This is because other factors over-powered the interest rate differential effect. One of these factors is resurgent economic growth outside the US (although this has dissipated recently). Another is the growing US “twin deficit”, which refers to both a fiscal and current account deficit. This also contributed to US dollar weakness in the early-2000s.

The US dollar is trading at the higher end of its recent range. Going forward, we expect modest US dollar weakness, especially against sterling.

Final Thoughts

Since the US Presidential election, the S&P 500 has returned approximately 30%. This is in line with MSCI’s index of developed world stocks with the greatest exposure to China. Meanwhile China A-shares have fallen over 10%. A global trade war will lead to winners and losers, and China has a lot more to lose than the US. The Trump administration knows this and will likely press the matter until reaching adequate trade concessions. However, just focusing on trade issues ignores important changes in Chinese monetary policy and growing signs of a domestic slowdown.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited and Lipper for Investment Management. Date of data: 16th July 2018

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